Passive activities and real estate persons: understanding the RRA '93 requirements. (Revenue Reconciliation Act of 1993)by Young, James C.
RRA '93 provides relief for a real estate person from the passive activity rules regarding rental real estate. To qualify such a person must pass tests involving personal services, real property businesses, and material participation. And what if the owner is a C corporation? An explanation of the complex requirements follows, with flowcharts to help.
Prior to the Revenue Reconciliation Act of 1993 (RRA '93), rental real estate activity was automatically classified as a passive activity. Even if the owner of the real estate devoted full-time to owning and managing the real estate, the activity was still passive because the material participation test did not apply to rental real estate.
The owner of a nonrental real estate business is eligible to use the material-participation test. If the owner has material participation, the business is a non-passive activity. Ever since the enactment of IRC Sec. 469 in 1986, "real estate professionals" have been seeking an exception that equates their situation to that of business owners generally.
New IRC Sec. 469(c)(7) is a partial solution to the real estate professional's passive activity situation. The provision allows "real estate persons" to deduct rental real estate losses against their nonpassive income, while creating three new qualifying tests. The provision is effective for taxable years beginning after December 31, 1993.
Exhibit 1 provides a flowchart to understand the general structure of the exception. Exhibit 2 (a rental activity determination flowchart) and Exhibit 3 (a material participation flowchart) both supplement Exhibit 1.
Key Strategy Change. Prior to the enactment of IRC Sec. 469(c)(7), taxpayers would have to "unbundle" their other real estate activities from their rental real estate activities to avoid the passive loss provisions. Now that may not be as necessary.
Also, as discussed later, the carryforward loss from a (formerly) passive rental real estate activity can be either offset against the earnings of the activity after it becomes nonpassive or deducted when the activity is disposed of.
Proposed Regulations. Proposed reugulations to the RRA '93 provision were issued on January 1, 1995, and are primarily incorporated in Reg. Sec. 1.469-9.
Variable Impact of IRC Sec. 469(c)(7). Some formerly passive rental real estate activities that generate losses will now help reduce nonpassive income; however, rental real estate activities that generate profit may also become nonpassive, thus reducing the deductibility of remaining passive activity losses.
Definition of "Real Estate Person"
IRC Sec. 469(c)(7) incorporates changes that allow the "real estate person" to treat rental real estate activities as nonpassive activities. A real estate person is one engaged in a rental real estate activity. That rental real estate activity is a nonpassive activity if -
Test #1: more than 50% of the taxpayer's business personal services are performed in real property businesses;
Test #2: the taxpayer performs more than 750 hours of personal services in real property businesses during the year;
Test #3: the taxpayer materially participates in the real property businesses; and
Test #4: the taxpayer materially participates in the rental real estate activity.
Material participation is defined by IRC Sec. 469(h) and the regulations. Material participation in the real property businesses, not just in the rental real estate activity, is required. Although the most commonly used material participation test is the more than 500 hour test, it is only one of seven tests ILLUSTRATION FOR EXHIBIT 3 OMITTED. As a result, the taxpayer must meet the material participation test three times. The taxpayer must have material participation in -
* those real property businesses that comprise the set in which the taxpayer meets the "more than 50% personal service" test;
* those real property businesses that comprise the set in which the taxpayer meets the "more than 750 hours" test; and
* the rental real estate activity itself.
Material participation may be "borrowed" from a spouse filing a joint return with the taxpayer. The spouse's participation is added to the taxpayer's participation to determine the total participation. No such aggregation is allowed if a married, filing separately return is filed. However, watch out for this trap when the couple is divorcing!
"Personal services" is not defined by the statute. Personal services includes work as an employee or self-employment. Services as an employee of a real estate business are personal services, but do not count toward the more than 50% test and the 750-hours test unless the taxpayer is at least a 5% (directly or indirectly) owner of the employer.
Example 1: Personal Services Ineligible. Fred works as an employee for a real estate sales company. He is not a shareholder. Fred also owns a rental real estate property. Fred works 1,760 hours as an employee of the real estate company and 535 hours managing his rental properly. Fred is not a qualifying real estate person because he had neither more than 750 hours nor more than 50% of his personal services in a real property business. Fred's rental real estate activity would be passive.
Example 2: Personal Services Eligible. If Fred owned 5% or more of the real estate sales company, he would have more than 750 hours of his personal services in a real estate business. He also would meet the more than 50% test and would have material participation in the rental real estate activity. Fred's rental real estate activity would be nonpassive.
Example 3: Spouse Participation. Bill and his wife Irene jointly own two rental real estate properties. Bill owns 100% of a real estate construction company. He works 2,310 hours a year there. Irene is a school teacher and manages their rental properties for 170 hours each per year. Hers is the only participation. The rental properties are combined into one activity. Bill is a real estate person. The rental real estate is a material participation activity because of the second material participation test, substantially all participation is done by Irene.
Example 4: Comparative AGI. Phil and Sue Garner own two rental properties: a house in the town where they live and a condominium in Florida. They manage the local house rental, but have the condo in a rental pool. Both houses are owned jointly and the Garners file a joint return. Phil is a self-employed real estate broker. He worked 1,760 hours as a broker. Sue is a school teacher. Phil worked 25 hours on the local rental house and Sue worked 10 hours on it. No one else did any work on the local rental house. Sue worked 5 hours on the Florida condo and Phil did no work in connection with it. The local house has a $13,000 current-year net loss. The Florida condo has a $5,600 current- year net loss.
The local house qualifies for the 1994 real estate person exception because Phil meets the "more than 50%" and "750 hours" tests. Phil materially participates in the local house rental real estate activity because his participation and that of his wife constitute substantially all participation by individuals during the year. The $13,000 loss on the local rental house is deductible against the Garner's income from nonpassive sources.
The Florida condo does not qualify for the real estate person exception. It also does not qualify for the $25,000 rental real estate loss exception because the Garners were not active enough in that activity.
Real Property Business
Real property business includes a wide variety of real estate involvement. Included in the statute are involvement in real property -
Each rental real estate activity is separately tested against the standards outlined above unless the taxpayer elects to treat all interests in rental real estate as one activity. For passive activity purposes, another aggregation election can be made. That election is binding if the taxpayer made it for rental real estate endeavors on prior-year returns.
IRC. Sec. 469(c)(7) allows a "second chance"; either each rental real estate activity is treated separately (general rule) or an election may be made to combine all rental real estate activities for purposes of the real estate person exception.
Example 5: Joan Has Three Rental Houses. On her 1993 return she combined Houses #1 and #2 into one activity. House #3 was treated as a separate activity. For her 1994 real estate person exception testing, Joan has two rental real estate activities: Houses #1 and #2 and House #3. She could elect to treat all the houses as one activity for purposes of the real estate person exception.
The real estate person exception cannot be used for an end run around the passive activity material participation tests. For instance, if one of the real property interests is a limited partner interest in a real estate partnership, the real estate person exception cannot be used to convert the limited partnership interest into a material participation activity. Notice ILLUSTRATION FOR EXHIBIT 3 OMITTED that a limited partnership interest is not automatically passive. The real estate person exception just does not make such an interest subject to any easier standards of material participation.
What if the Owner of the Rental Real Estate Is a C Corporation?
Four tests must be met for the rental real estate activity to be nonpassive.
Test #1: The corporation must be a closely held C corporation. Such a corporation has five or fewer shareholders owning more than 50% of the value of its stock during the last half of the tax year.
Test #2: More than 50% of the corporation's gross receipts must be from real property businesses.
Test #3: The corporation must materially participate in its real property businesses.
Test #4: The corporation must materially participate in the rental real estate activity.
For a closely held C corporation, material participation means one or more shareholders, owning in the aggregate more than 50% of the value of the corporation's stock, materially participate as a group. S corporations are not included in these tests because qualification for the real estate person exception is tested at the shareholder level. Exhibit 4 summarizes the passive activity rules for C corporations prior to the real estate person rules.
Example 6: Corporate Nonpassive Rental Real Estate. AHR Services, Inc. (a C corporation) has three shareholders. One of the shareholders, Bob, works 1,580 hours per year as an AHR employee. The other two shareholders work about 80 hours per year as members of the board of directors. AHR provides cleaning and maintenance services for commercial buildings. It also owns a small office building with tenants unrelated to AHR. Bob spends 85 hours managing the office building and that is substantially all the participation. AHR's rental gross receipts are 60% of the total gross receipts. The corporation is a closely held C corporation. There is material participation under the second material participation test. Income from the small office building would be considered non-passive only if the corporation's main business of cleaning and maintenance is considered real property business.
Impact on Formerly Passive Activities
Rental real estate activities that were passive in 1993 and prior years will frequently become nonpassive in 1994 and later years because of the real estate person exception. The passive-loss carry-overs from before 1994 will be usable only against the profit from the formerly passive activity or will be usable when the activity is completely disposed.
The real estate person exception is not elective. Thus profitable rental real estate activities that qualify under the real estate person exception will also be treated as nonpassive. Consequently, the real estate person exception may have an adverse affect on the deductibility of other passive activity losses. Also, rental real estate activities qualifying for the real estate person exception will not qualify for the (up to) $25,000 rental real estate loss exception. However, the "modified AGI" used to phase out the $25,000 exception does not include a reduction for any rental real estate losses that are deductible because of the real estate person exception.
Exhibit 5 summarizes some of the real estate person planning implications.
REAL PROPERTY PERSON EXCEPTION: PLANNING IMPLICATIONS
Taxpayers' personal services and what those personal services are related to are extremely important; information on those personal services will be needed.
Rental real properly which is held jointly and where at least one spouse materially participates in the rental real estate activity does not necessarily qualify for the special real estate person exception; at least one spouse would have to have more than 50% personal services to have all the losses qualify as nonpassive.
Carryforward Passive Losses
Carryforward passive losses from taxable years beginning before 1994 do not qualify for the special exception; those losses remain suspended until the activity is completely disposed of or it has a profit; consequently, taxpayers with such carryovers may want to avoid qualifying for the real estate person exception if the activity becomes profitable. Why? Because the profit will be nonpassive and only available to offset that activity's carryforward passive losses, not other activity passive losses.
Material participation is unlikely for a limited partner and so is more than 50% personal service in a real property business; however, combinations involving personal service in other real property businesses plus the use of limited liability companies might be an interesting investment approach. Unfortunately, IRC sec. 469(c)(7)(A)(last sentence) and Reg. sec. 1.469-9 (f)(1) restrict aggregating limited partnership rental real estate interests with other rental real estate.
Steven C Dilley, PhD CPA, is a professor at Michigan State University. James C. Young PhD, CPA, is an assistant professor at George Mason University.
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